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Financial Systemic Risk Problem Hasn't Been Fixed

Goldman Sachs and JPMorgan Chase have reported huge profits, the Dow has made it past 9000, and Barack Obama has moved on to health care. The horror show seems to be over. But as in one of those clichéd Hollywood endings, the monster in this story isn't really dead, even if most people think he is. Lost amid all the premature self-congratulation is the fact that the deepest underlying problem that caused the financial disaster is not being solved.

The problem: how to control and keep tabs on the market activities of giant firms that cause such a disruption to the system they can't be allowed to fail. Put simply, six months into the Obama administration there is as yet no coherent proposal for solving this issue, and serious differences remain between Tim Geithner's Treasury and Ben Bernanke's Fed. At hearings this week, Sen. Bob Corker (R-Tenn.) told Bernanke bluntly that he didn't think anyone was up to that immense and vastly complex job. As Corker told me afterward in an interview: "Today there's a whole lot more questions about what systemic risk is and which powers a regulator should have than there are answers. And the last week has brought that to light."

Indeed. On Friday, Geithner reiterated a position he first laid out in June: the administration, he said, wants to hand the job of systemic risk regulator to the Fed. "We propose evolving the Federal Reserve's authority to create a single point of accountability for the consolidated supervision of all large, interconnected firms," he said in testimony. He said again that the administration seeks to create a new Financial Services Oversight Council to monitor systemic risk. But Geithner made clear the council "will not have the responsibility for supervising the largest, most complex, interconnected institutions." Geithner said there's no way such a council would have the "tremendous institutional capacity and organizational accountability" needed for that task, or to respond in a financial emergency. "You cannot convene a committee to put out a fire," Geithner summed things up piquantly in June. "The Federal Reserve is in the best position to play that role."

But Bernanke, in contending testimony this week, shied away from being cast as the über-regulator. Instead, as he saw it, the Fed ought to be restricted to being supervisor of bank holding companies--apparently the same 19 giant firms that went through "stress tests" last spring. "We don't have the resources or the authority" to take "a holistic view of the whole system," he said, "though, of course, in general terms we obviously are watching the economy, but not in that kind of detail." Bernanke also expressed a lot more enthusiasm than Geithner about the council, urging Congress to debate "what powers it should have." He added: "There may be situations where the council can have authority to harmonize different practices or to identify problems and to take action."

When Sen. Mark Warner (D-Va.) pressed Bernanke on this point, he demurred again. Warner asked: "Are you comfortable that the Fed is the de facto systemic-risk overseer at this point; is aggregating enough information upstream from all the day-to-day prudential regulators, not just on the banking side, but from securities, commodities and others--that this aggregation of information is taking place?" Bernanke responded: "Well, no, we're not being the super-regulator at all." Federal Reserve governor Dan Tarullo, an Obama appointee, emphasized the same point in testimony on Thursday. While a new financial regulatory framework "would involve some expansion of Federal Reserve responsibilities, that expansion would be an incremental and natural extension of the Federal Reserve's existing supervisory and regulatory responsibilities," he said.

Both Bernanke and Geithner argued that other planned measures will ameliorate systemic risk. Under the administration's proposals, big firms will have to "bear the cost of their size through extra capital, liquidity and risk-management requirements," Bernanke said. In other words, there will be an additional cost to bigness that wasn't there before, making M&A enthusiasts think twice. Second, a new resolution authority will be able to take over big firms the way the Federal Depository Insurance Corp. does to banks, raising the prospect "that creditors could lose money if the company fails," Bernanke said. "Both of those things would tend to make being big less attractive." The Fed chief added that under the new regime, "supervisors would choose to tell firms that they needed to limit certain activities if they thought it was a danger to the broad system."

All this helps. But it may be a triumph of hope over experience that Wall Street will decide to get smaller when competing against other global giants, just because of the extra cost of doing business. And it is similarly wishful thinking to believe that the hazy job of systemic-risk regulator that no one seems to want--however it ends up being structured--is going to decide that a future AIG shouldn't get into a certain kind of credit default swap, or that a JPMorgan Chase can't develop some new kind of collateralized debt obligation. The administration and the Fed have ignored more fundamental calls for change. For example, they have swatted aside a proposal by former Federal Reserve chairman Paul Volcker, the head of Obama's Economic Recovery Board, to bar commercial banks that enjoy federal guarantees from proprietary trading of risky instruments like derivatives. For the most part, the current measures will make it easier to clean up after the next mess. But they won't prevent another mess from happening.